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Friday, July 26, 2013

Managing HR Risk: Micro Versus Macro

It's an interesting question, at least I think it is; when looking at risks inherent in benefits and compensation programs, should a company look at them on a macro basis or a micro basis? Or said differently, do lots of small unattended risks add up to a large risk that if it were in a single program would be viewed as untenable?

One could probably look at some of the variety of public entities which either are seeking or have sought protection under Chapter 9 of the United States Bankruptcy Code. Additionally, we could examine those that are probably considering such action whether or not deliberations have been in the public eye. What makes them especially relevant to this question is that in so many cases, the costs that are causing these cities and counties to go bankrupt are related to benefits and compensation. They are, after all, the largest budget items for many of these entities.

How did they get to this point? We could get into a political debate here, but that is not my objective. I know that some of my readers lean left while others lean right. We could get into a debate about public unions, but again that's political and one sentence later, it remains not my objective.

Many cities, counties and other government entities provide generous benefits. The often include defined benefit pension plans that would be unheard of in the private sector, health care benefits that would be considered "Cadillac Plans" under the Affordable Care Act (ObamaCare), large amounts of bankable paid time off sometimes as a single quantity and sometimes as vacation time and sick time separately.

The accounting profession through GASB standards has brought attention to the liabilities associated with these costs. Funding of these obligations, however, is usually subject to municipal or state law and there have been some notable cases where local government may have played fast and loose with those laws.

Why do I raise these issues? Benefits were not always as generous as they are today. But, they creep up. In good times, they are enhanced. Look, we have a surplus this year, we can afford to enhance this benefit. Each time this is done, there is a new, albeit small, risk added to the total risk pie.

Suppose a public entity has a $1 billion annual budget and this new enhancement only increases annual costs by $1 million. That's only 0.10% of the annual budget. Surely, it must be affordable. And, frankly, if you thought about it on a personal level, you would probably agree. If you have an annual income of $100,000, a $100 annual increase in costs would not change your life. It's only about $8.33 per month. It's less than 3 cents per day. But, you all know what happens, you don't just take on a single $100 increase, you take on a bunch of them and all of a sudden, you have a meaningful increase in costs and with it, a meaningful increase in risk. So go the public entities as well.

This sometimes happens in the private company world as well. Because of things like ERISA and the Internal Revenue Code, there are more funding rules and they cannot be ignored. But there are lots of benefits and compensation programs that need not be funded. You know what, they add up. Have too many of them and it starts to affect the bottom line. But when companies look at this on a micro basis, there doesn't appear to be a problem. You might hear a conversation that goes something like this:

"We have annual revenues of $1 billion, so where is the problem?" "I don't know, we haven't changed anything with meaningful cost." "Maybe our consultants messed up. When I look at our changes over the last few years, they didn't price any of them out to cost more than $500,000 per year [they forget to mention that there have been 25 such changes over the last 10 years each with estimated cost projections, but that all of those estimates come with inherent volatility and therefore risk], so maybe we should look to see where they messed up."

Suppose the company had looked at all 25 changes together. And, further, suppose they had looked at them stochastically and considered the dreaded left tail -- the worst 5% of all plausible occurrences. Wow, this entails some real risk!

So, while it's okay to consider changes that have costs and to be a bit more cavalier about ones that have small costs, companies should always consider them in a more macro context. What other changes have been made recently or are they considering? What is the interplay between the costs and attendant risks? How do they correlate? Will the costs escalate at the same time as business has a tendency to go bad?

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